The “Ugly Truth” About Bankruptcy and IP Licensing in the US

It’s a very common scenario – a collaboration agreement and/or exclusive licensing deal is struck between a small start-up and a much larger partner with the promise of product development for the larger organization based on basic technology developed by the smaller outfit.  Unfortunately, bankruptcy of the smaller partner following the deal is also commonplace, especially in challenging economic times.  The bankruptcy event can pose a major setback or even a financial catastrophe to the larger organization (due to the potential loss of significant research and development dollars funneled into programs reliant on the deal with the now defunct partner).

 

Bankruptcy law is complicated.  IP law is complicated.  Understanding the intersection of these two fields is daunting.  That said, here are some basic concepts passed on from various bankruptcy lawyers (as always if you need specific advice, reach out to an expert rather than relying on a blog).

 

When an organization goes bankrupt it typically is under the control of a debtor-in-possession (DIP) which acts under (various amounts) of supervision from the government/courts.  The DIP usually is the organization itself operating in bankruptcy.  Successors could be either the reorganized DIP or organizations that acquire portions of the now bankrupt organization.

 

How contracts that the bankrupt organization are treated depends on their nature.  Contracts can either be “executory” (something remains to be done by one or both parties) or non-executory.  Most contracts are executory (it doesn’t take much).  A DIP (and its successor, if any) has to live with non-executory contracts, but can either reject or assume executory contracts.  That’s where things get tricky.  If the DIP rejects the executory contract, the contract essentially ceases to exist.

 

US law provides some protections for licensees of intellectual property in terms of Section 365(n) of the Bankruptcy Code.  Many licenses include standard provisions invoking this section as a protection.  On its face, 365(n) appears to ensure that the licensee will maintain its exclusive access to the licensed intellectual property.  If only it were that simple . . .

 

A license under 365(n) comes with significant limitations.  Moreover, US bankruptcy law imposes other restrictions that impact how a company can protect itself from an undesirable bankruptcy of a partner.

 

First, US law voids clauses that equate bankruptcy with breach.  While such clauses might be effective for a localized (single state) bankruptcy or foreign bankruptcy, they have no power under US federal law.  On top of that, US bankruptcy law voids or at least greatly undermines any claims made near the point in time the company goes bankrupt (during the so-called preference period, which usually runs 90 days from the bankruptcy).

 

Second, the protections of 365(n) only extend to access to the license to the intellectual property.  365(n) does not require the DIP or its successor to prosecute, maintain, or even enforce patents!  In other words, the exclusive license may not give you the kind of exclusivity you think it might.  In a collaboration, all of the performance obligations that remain outstanding similarly can be avoided after the bankruptcy. 

 

Note also, that “intellectual property” under 365(n) does not include trademarks.

 

So what can you do to protect your client/organization from such problems?

There are a number of strategies that can be employed to address these problems.  These include:

  • splitting royalties into enforcement/maintenance and licensing components;
  • requiring transfer of the IP with a back-license (or transferring to a joint venture, such as a “bankruptcy proof” IP holding company… but watch out for tax and enforcement issues with that kind of approach);
  • using security interest agreements rather than licenses; and
  • using financial triggers that arise well in advance of bankruptcy to provide an opportunity to acquire the IP of interest

There are just a sampling, but hopefully at least inspire some thinking on the issue.  Good luck!

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